Business Roundtable

The following published materials are submitted on behalf of the Business Roundtable, an association of chief executive officers of leading corporations with a combined workforce of more than 10 million employees in the United States and $3.7 trillion in annual revenues:

"SEC Proxy Proposal May Give Hedge Funds Too Much Power," by Sara Hansard, published in Investment News on Monday, November 24, 2003.

"The SEC Must Correct Its Proposed Direct-Access Rules, or Corporate America Will Face a Wave of Proxy Battles," by Charles M. Nathan, published in The Daily Deal/The Deal on Monday, November 24, 2003.

"The SEC's Proposed Rules on Shareholder Access Could Dramatically Change Board Composition and Corporate Culture," by Edward Young, published in The Daily Deal/The Deal on Thursday, October 16, 2003.

A copy of each of these publications is attached hereto for inclusion in the public comment file for File No. S7-19-03.

Hedge funds may be the primary beneficiaries if a proposed regulation giving shareholders greater access to corporate proxy nominations is approved.

That is the assessment of Martin Lipton, a founding partner of the New York law firm Wachtell Lipton Rosen & Katz who specializes in advising corporations on mergers and acquisitions. He opposes a proposed regulation by the Securities and Exchange Commission that would give shareholders limited access to the proxy-nomination process (Investment News, Oct. 13).

Some fear that the proposal would allow unions and social activists to get directors' seats on corporate boards to advance their specific interests without regard to the overall good of the company. Mr. Lipton's main concern, however, is the impact hedge funds could have on corporate decision-making.

"What I'm really worried about are the hedge funds and the vulture funds and the other people who will see this as a great opportunity to force companies into transactions that may be good for the hedge fund or good for the vulture fund but may not be good for other security holders," he said at a mid-November forum on capital markets, sponsored by the U.S. Chamber of Commerce in Washington. "It surely won't be good for other stakeholders."

influencing Boardroom decisions

If the proposed regulation were enacted, it would give hedge funds "enormous power to affect what happens in the boardroom of companies," Mr. Lipton predicted. "No company wants to face a contest with respect to election of directors," he said. That could cause corporate boards to be more compliant with the demands of shareholders who threaten to contest elections, Mr. Lipton argued.

He cited SEC rules requiring mutual fund companies to disclose proxy votes, saying the rules have resulted in investment companies' more aggressively asserting a role in corporate decision-making. Those companies "don't want to spend the money on company-by-company analysis" as to how they should vote on each proxy, Mr. Lipton said. Fund companies get advice on how they should vote from proxy research organizations such as Institutional Shareholder Services Inc. in Rockville, Md. "Unfortunately, most of this advice is across the board - vote against staggered boards, vote against poison pills, vote for spinoffs and so on.

Good governance

"We will end up in a situation where any hedge fund can buy into a company ... and use the mere pendency of the access proposal to pressure the board of directors to make a change that the proponents are interested in accomplishing," he said.

Mr. Lipton added that board members are nervous about being charged with not exercising good governance. The result may be to destroy the collegiality between corporate boards and management.

"Directors are going to be less receptive to risk-taking," he said. "They're going to want management to not undertake things ... that might provoke the activist shareholders, whether they be the environmentalists, the unions, or the hedge funds or vulture funds."

Jamie Heard, chief executive of Institutional Shareholder Services, favors the SEC proposal. He noted that under the proposed regulation, stakeholders seeking to use company resources to nominate directors could do so only if more than 35% of shareholders withheld votes on a director candidate.

In that event, more than half of the shareholders would have to approve a proposal to gain access to the proxy process, and shareholders who owned at least 1% of voting shares for at least a year could then submit a proposal. Mr. Heard said those stipulations would be hard to meet, limiting the use of the measure. Under the proposed rule, no more than three directors could be nominated, and shareholders could not nominate a majority of directors.

He also said votes encouraged by unions and social activists have proved far less popular among shareholders than votes for corporate-governance measures.

"I believe this proposal won't actually be used very often," Mr. Heard said. "What will happen is, it will serve as a reminder to boards of directors, if they are unresponsive, that there is a way for shareholders to step in."

He said his concern is that institutional shareholders such as mutual funds should become more active in fund governance. Mr. Heard commended The Vanguard Group Inc. of Malvern, Pa., which he said is now withholding votes on directors at the rate of 30% to 40%. Vanguard has also voted against more than half of the option plans proposed by companies whose stock it holds, he added.

The Securities and Exchange Commission's proposed rules for direct shareholder nomination of directors are premised on the concept that allowing a limited number of direct nominations each year is good policy, but allowing an unlimited number of direct nominations each year would wreak corporate governance havoc because of the cost and dissension proxy contests necessarily engender.

For this reason, the SEC's rule proposal requires a "trigger event" at a corporation before direct shareholder nominations are permitted. The proposal also requires the nominating shareholder group to have owned a 5% block of stock for a minimum of two years. While these limitations may seem imposing, in practice they will be illusory, and corporate America will face the prospect of myriad threatened and actual proxy fights.

The first trigger event for direct shareholder nominations is adoption by a majority of votes cast of a shareholder proposal from a 1% or greater shareholder to opt into the direct shareholder nomination procedures.

It is unclear whether the SEC thinks the 1% ownership requirement is a safeguard. If it does, it is wrong. Many activist institutions own more than 1% of many companies, and where they don't they can easily band together to get to the threshold.

This leaves only the question of whether institutional investors in general, and not just the activist institutions, will vote in favor of triggering proposals. The SEC thinks not, because it believes a trigger proposal would be a major change in corporate governance that would get adopted only if shareholders were truly distressed with a company's governance, management or performance.

This belief ignores two critical factors. First, adopting a triggering proposal creates an option that otherwise would not exist because it opens the possibility for direct shareholder nominations at the next two annual meetings. Absent the triggering event, it would take two years, not one year, to actually launch a direct shareholder nomination campaign. Institutional investors are financial creatures, and they understand that options are valuable because they create an opportunity even if never exercised.

Second, and more important, institutional investors don't think about each vote they cast and don't want to. Rather, institutional investors vote on shareholder proposals either according to recommendations of Institutional Shareholder Services or according to rote voting policies that in practice allow no deviation.

The informal acceptance by ISS of the corporate governance philosophy of the activist institutions and the Council of Institutional Investors makes it almost certain that ISS as a matter of policy will recommend voting in favor of triggering proposals. Those institutions that eschew reliance on ISS nevertheless also avoid case-by-case decisions and controversial positions in their voting policies. These considerations also dictate a rigid policy of voting for triggering proposals. The outcome is foreordained. Triggering proposals will get 50% of the votes cast as a routine matter.

The second trigger event in the SEC proposal is the withholding of 35% or more of the votes cast on any director nominee. This trigger is also illusory. Institutional investors can launch "withhold campaigns" without giving notice to the company or making any SEC filing. Activist institutions, moreover, can target a director for any reason ranging from the number of directorships he holds to his personal views on issues related or unrelated to the company in question to a simple campaign to create a trigger event. The activist institution community is plotting withhold campaigns at several companies for the 2004 proxy season because it believes this goal will be easier to achieve than 50% of the votes cast on a shareholder proposal to opt into direct nominations.

The practical ineffectiveness of the trigger events leaves the 5% ownership requirement as the only effective barrier to an onslaught of direct shareholder nominations. While a 5% holding for two years is not negligible, it is probable that activist institutional investors will be able to assemble 5% holdings with relative ease through direct contact, e-mail solicitations and the informal network of activist institutions centered around the Council of Institutional Investors.

The problem is clear: The SEC has miscalculated the limiting effects of the trigger events and other qualifications for direct access.

The remedy is equally clear: The SEC needs to revise its triggering events to have a more meaningful effect. Absent this remedy, adoption of the direct-access rules will herald a new era of direct shareholder nominations and election contests across corporate America.

If more insurgent nominees get elected to public company boards under newly proposed Securities and Exchange Commission rules, board composition and corporate culture could change markedly, and serious issues of collegiality, confidentiality and fiduciary duty may result.

Allowing dissatisfied shareholders holding 5% or possibly less of a company's float to place one or more nominees on the company's own proxy card would substantially reduce the time and expense involved in running a dissident short slate under existing rules -- factors that deter all but the most determined and well-financed shareholders from engaging in proxy contests.

Already, companies that perceive themselves to be in the cross hairs of one or more dissident shareholders are considering defensive measures to forestall challenges to incumbents. Although the proposed rules limit the number of shareholder candidates who can be elected in any year, the worst fear of incumbent directors is that a contest for a limited number of board seats in one year under the new rules may leave the company exposed to a change-in-control contest the next year.

The new rules will undoubtedly increase the influence of large shareholders in the context of board composition and beyond. Even without invoking the shareholder access process to elect candidates, substantial shareholders or groups of like-minded shareholders may enjoy increased leverage if they are perceived as willing and able to make the company vulnerable to a contest.

The election of new directors who owe their nomination and election to a different subset of shareholders than the incumbent directors will likely come as a shock to the boardroom culture of many companies. The incumbents may worry that efficient, collaborative decision making will diminish and posturing will replace candor.

Fiduciary duties may pinch new directors. Courts have become ever more vigilant in enforcing directors' fiduciary duties of good faith and loyalty to all shareholders. The actions of a director who is beholden to a particular shareholder constituency may be open to legal challenge whenever an issue arises that affects his constituency differently than it affects other shareholders, such as putting a company in play as an M&A target.

Likewise, incumbent boards will need to comply strictly with fiduciary duties when considering possible defensive measures. Their permissible scope of action will be greater if they act before a specific shareholder challenge to the directors becomes reasonably foreseeable.

Heading the agenda for immediate adoption, where not already in place, are bylaw provisions requiring advance notice for shareholder nominations. It is unclear whether companies will venture into uncharted legal waters by adopting bylaws that are more onerous than the new rules regarding nominations -- for example, requiring any shareholder that makes a nomination to continue to hold all its shares through the date of the meeting.

Bylaw amendments might also impose objective criteria for director nominees such as industry experience, prior service on other public company boards, the absence of ties with competitors and/or a limitation on the number of other boards a director can serve on concurrently. Obviously, seeking to impose standards for new directors that are any more stringent than standards for incumbent directors would raise serious fiduciary concerns.

A board that does not already have an executive committee may want to consider establishing one well before any new directors can be added pursuant to the shareholder access process. Key parameters include the mix of management and nonmanagement directors on the committee, the scope of the unit's mandate and the relative frequency of board and executive committee meetings. Sharp disagreements may arise, however, as to whether new directors should be added to executive committees when and as elected.

Companies with no formal policies or procedures governing board meetings may wish to adopt procedural codes that balance the right of dissenters to be heard against the necessity of conducting the board's business. Directors with ties to a particular constituency will presumably be asked to recuse themselves from discussions involving matters relating to their constituency.

Confidentiality is a key legitimate concern, and doubtless many companies will require all directors to countersign newly adopted confidentiality codes. Companies may also seek to impose ethical walls between directors and third parties (including shareholders) going beyond unannounced material information that is governed by Regulation FD. For example, directors might be allowed to impart information to shareholders only in formal sessions, accompanied by other directors or a company shareholder relations officer.